Why Expanding Student Loan Interest Deductions is Unwise

The United States Congress has rarely met a change to the tax code that it doesn’t like. Since 2011, Congress has made nearly 5,000 changes to the tax code, making the tax code even more Byzantine and causing many Americans headaches each spring. While the exact levels and types of taxes preferred by the public tend to differ by political and economic ideologies, a general consensus exists among economists that a stable, predictable, relatively simple tax code achieves revenue goals at a reasonable cost.

Yet Congress is constantly faced with pressure to change the tax code to allow more credits and deductions to incentivize certain activities. We have certainly seen incentives in the tax code to increase educational attainment through the use of credits and deductions. These incentives have a difficult time being effective in inducing students to obtain more education because students and their families do not receive a financial benefit until well after the enrollment decision has been made, and awareness of these programs is uneven at best.

The deduction for student loan interest payments is designed to help student be able to repay their educational debt; currently, students can receive a $2,500 deduction on their taxes (if they itemize) in a given year and their income is less than $75,000 per year if single or $150,000 per year if married filing jointly. It is hard to imagine that such a program, which does not provide a financial benefit to students until after they have left college, will help increase educational attainment.

Yet Congressman Charles Rangel (D-NY), who is well-known for his 2012 censure over failing to pay taxes, has introduced the Student Loan Interest Deduction Act, which would double the tax deduction for student loan interest and get rid of the income cap for receiving the deduction. This bill has picked up the support of many higher education associations, including the American Council on Education and the National Association of Student Financial Aid Administrators, but it is an example of inefficient and misguided public policy.

Here are a few reasons why the proposed bill is poor public policy:

(1)    Students get the tax deduction years after beginning college. Yes, students with perfect information about the deduction (and who believe the policy will remain in place) will adjust their total cost of college down. But that requires a large amount of information and a low discount rate, neither of which can be assumed.

(2)    Increasing the deduction cap allows students to benefit more if they took out more debt. This can provide an additional incentive for colleges to raise their price and capture additional revenue if they think students will pay.

(3)    Getting rid of the income cap shifts the benefits more toward higher-income families, who are more likely to itemize deductions and be able to use the deduction. Advocates on the left should be particularly steamed by this point.

(4)    This acts as an additional tax on saving for college relative to borrowing, and can place families who chose not to borrow at a disadvantage.

I would prefer to see all interest deductions removed from the tax code and replaced with more efficient upfront payments. Instead of forgoing billions of dollars in revenue through tax credits and deductions, I would rather see the money used in grant programs, lowering the interest rates for federal loans, or used toward other educational improvements. Rangel’s bill just complicates the status quo and does little to actually help students afford college.

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About Robert

I am an assistant professor of higher education at Seton Hall University. All opinions are my own.
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8 Responses to Why Expanding Student Loan Interest Deductions is Unwise

  1. Justin says:

    Your third criticism is based on a false premise. The Student Loan Deduction is an above-the-line deduction, eligible to people who take the standard deduction or who itemize deductions (http://www.irs.gov/taxtopics/tc456.html).

    • Justin says:

      Well, your third criticism has two parts, one being that itemization is required, which tends to help the wealthy, and the other being that the income cap is removed, which primarily benefits the well-off. The latter criticism is still valid.

  2. Robert says:

    Thanks for the comments, Justin. I agree that you don’t have to be wealthy to itemize, but the two are reasonably well-correlated. My biggest gripe with the bill (which not surprisingly hasn’t gone anywhere since I wrote this post a few months ago, given GOP control of the House) is that it would make more sense to give money to students and families upfront instead of later on.

    • Justin says:

      I agree with you that it would make more sense to give money to students and families upfront. As for what I said above, you are misunderstanding me. I am not saying that you do not have to be wealthy to itemize (I acknowledge that wealth and itemization are well-correlated, as you note). I am saying that the student loan deduction is an adjustment to income, not a tax deduction under itemization. That is to say, every single person who files a 1040-variety form can claim the student loan deduction, regardless of whether they take the standard deduction or whether they itemize (hence, the IRS says in the above link that “The deduction is claimed as an adjustment to income so you do not need to itemize your deductions on Form 1040, Schedule A (PDF).”).

      All of your other criticisms seem good to me. I just wanted to point out that itemization is irrelevant to the student loan deduction.

  3. Changing the amount you are able to deduct from your taxes will incentivize/de-incentivize third parties regardless of the specific number you choose. I do appreciate the analysis that a change in the deduction amount may have a certain impact.

    Regardless of that fact, I don’t understand the rationale for even having a limit on the amount you can deduct to get an education? I’m not actually gaining anything material except for the potential to earn more money later (which will be taxed.)

  4. Geeps P says:

    Your 1st point – completely ignores the actual, compounding problem in American today. For example, how many times have you read that millennials are not buying homes because they cannot? When you apply for a mortgage, the lender will evaluate your debt/income ratio. Guess what makes your income go down? Yup, a student loan interest deduction.
    First the fact that the tax deduction begins after college is not necessarily true. You can start paying off your loans while in college/graduate school.
    Further, even if the tax deduction does not begin until after college – so what? People went to school to invest in their life, education, and to increase their ability to earn a higher income (which is taxable). For those who seek very high degrees, such as a medical degree, why would we not want to allow these dedicated, smart students to deduct their high interest later on when they are working? Why keep them down?
    Are you against the mortgage interest deduction too? Would you propose that the deduction should only be at the moment you buy your home?

    Your 2nd point – Completely speculative–in the very negative, worst-case-scenario way. Who wants more debt just b/c you can deduct, say, $4,000/yr off now on your $35,000 debt? People want to get rid of their debt and former students would still be required to pay the principal amount off, plus interest. The deduction does not change that contractual obligation. It only changes a tax obligation, slightly I might add.

    Your 3rd point – shows you are very misinformed. The student loan interest deduction is allowed whether you itemize or not.

    Your 4th point – completely ignores the fact that there are already tax credits for those who pay tuition. Credits! Better than deductions. i.e. American Opportunity Credit, Lifetime Learning Credit, Hope Scholarship Credit.

    As for your alternative suggestions – they’re okay and commendable, except for eliminating deductions from the tax code. You do realize there are many former students that make up our economy now right? If we only implement your alternatives, what becomes of former students? Are you suggesting the benefit only apply from the prospective students and forward?
    This is not a solution for those who ALREADY have student loans.

  5. Jim says:

    A family of 4 making $150k in Manhatten or San Fran is basically living the same lifestyle and driving the same cars as a family of 4 in Missouri making $80k a year when you take taxes and housing costs into account. So how is it fair that the San Fran families deductions on student loans are phases out… But the Missouri family basically living the same lifestyle, driving the same Toyota Camry…. Saving the same for retirement…. Gets all the child credits and student loan deductions?

  6. Geeps P says:

    Robert,
    You are only thinking of the students *from now on*, not about students who graduated in a massive recession, and who are in the age range that should be stimulating the economy by making investments, buying homes, etc. Those people are in their late 20’s and 30’s. You are only thinking of the people who are planning for college right now.
    We are in a new economy now, and the mortgages that these people are paying are their student loans, not homes, like before.
    We give mortgage interest rate deductions for people. Why not do that for people who went through higher education, making due payments on their loans, and deduct that astronomical interest?

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